T.C. Memo. 1998-391

UNITED STATES TAX COURT

SRICHAI AND PUSADEE RUNGRANGSI, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 11257-97. Filed November 4, 1998.

Srichai and Pusadee Rungrangsi, pro sese.

Gretchen A. Kindel, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

JACOBS, Judge: Respondent determined the following

deficiencies, additions, and penalties with respect to petitioners'

Federal income taxes:

 Additions to Tax and Penalties

Year Deficiency Sec. 6651(a) Sec. 6662

1992 $8,517 $100 $1,703
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1993 22,226 1,514 4,445

1994 19,178 673 3,836

All section references are to the Internal Revenue Code for

the years in issue. All Rule references are to the Tax Court Rules

of Practice and Procedure.

The deficiencies herein generally relate to petitioners'

ownership and operation of a restaurant in Stanton, California.

The issues for decision are: (1) Whether a purported sale of a

restaurant (Stanton Mexicatessen) from petitioners to Suvanee

Eagatatt on September 15, 1993, should be recognized for tax

purposes, so that petitioners would be entitled to a capital loss

on the sale for that year; (2) whether petitioners properly

reported the income from the operation of Stanton Mexicatessen for

1992, 1993, and/or 1994; (3) whether petitioners are entitled to

deductions for investment interest expenses for 1992, 1993, and/or

1994; (4) whether petitioners are liable for additions to tax

pursuant to section 6651(a) for failure to timely file their tax

returns for 1992, 1993, and 1994; and (5) whether petitioners are

liable for accuracy-related penalties pursuant to section 6662 for

1992, 1993, and 1994.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The

stipulated facts are incorporated in our findings by this

reference.
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At the time the petition was filed, petitioners resided in

Cerritos, California.

Background

Mr. Rungrangsi was born in Thailand in 1938. He first came to

the United States in 1968 to attend Georgia State University where

he obtained a master's degree in economics. After obtaining his

degree, Mr. Rungrangsi returned to Thailand to work for the Thai

government. In 1979, Mr. Rungrangsi married and he returned to the

United States with Mrs. Rungrangsi and became a bartender in New

York. In 1980, petitioners moved to southern California and Mr.

Rungrangsi continued to work as a bartender; Mrs. Rungrangsi worked

as a registered nurse. 

After moving to California, petitioners began investing in

real estate. In 1984, they acquired commercial property in Long

Beach, California, and in 1987, they acquired a residence. In

1989, petitioners acquired a minimarket business in South El Monte,

California, with the equity from their house. They invested

approximately $120,000 to purchase the minimarket, but had

insufficient funds to purchase inventory. Consequently,

petitioners borrowed funds from Suvanee Eagatatt, a friend of Mrs.

Rungrangsi. Ms. Eagatatt obtained a home equity loan of $96,000

and lent the proceeds to petitioners without interest. Petitioners

were obligated to pay off the loan directly to Ms. Eagatatt's

lender.
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1 Petitioners also maintained personal checking and

savings accounts at Sanwa Bank, Bank of America, and First

Central Bank. 

In 1991, petitioners sold the minimarket (at a profit) for

$355,000. 

Stanton Mexicatessen Restaurant

On January 7, 1992, petitioners purchased Stanton

Mexicatessen, a restaurant located in Stanton, California, for

$355,000 (an apparent coincidence) from Sonia Finkelstein. To pay

for the restaurant, petitioners obtained a $100,000 loan from First

International Bank (secured by petitioners' residence), received

$85,000 in seller's financing (which was to be repaid at an

interest rate of 10 percent by January 7, 1995), and paid the

balance of the purchase price in cash, including the funds from Ms.

Eagatatt's home equity loan. 

Petitioners maintained two business checking accounts1 for the

operation of Stanton Mexicatessen. The first account (No. 0273-

15832) was held at Sanwa Bank (the Sanwa business checking

account). Petitioners, along with Somphob (Sam) Osathanond

(petitioners' nephew who assisted in the operation of the

restaurant), were signatories on this account. The second account

(No. 04422-09516) was held at Bank of America. This latter account

was opened on June 1, 1992, and closed on November 18, 1992. In

operating the restaurant, petitioners did not deposit all cash
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receipts into the business checking accounts; often they used the

receipts to make purchases (such as inventory). 

In 1993, petitioners began to experience financial

difficulties resulting in the foreclosure of a rental property. In

contemplation of bankruptcy, on September 15, 1993, petitioner

arranged for Ms. Eagatatt to sign and file a Notice To Creditors of

Bulk Sale pursuant to the Uniform Commercial Code (the bulk sale

notice) in Orange County, California, in which the assets of

Stanton Mexicatessen were purportedly transferred to Ms. Eagatatt.

(Petitioners received no monetary consideration for this transfer,

but the bulk sale notice indicated that Ms. Eagatatt was to assume

all liabilities of the restaurant.) Further, the lease for the

land on which the restaurant operated was amended to reflect the

transfer to Ms. Eagatatt. 

On or about September 29, 1993, petitioners filed for

bankruptcy protection from creditors. The record does not reflect

the type of bankruptcy protection petitioners sought. 

Preparing and Filing of Tax Returns

Petitioners' 1992, 1993, and 1994 joint income tax returns,

all of which were untimely filed, were prepared by professional

accounting firms. For 1992, petitioners reported on Schedule C,

Profit or Loss From Business, a loss of $23,005 from the operation

of Stanton Mexicatessen. Also for 1992, petitioners reported

investment interest expenses of $12,221 on Schedule A, Itemized
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Deductions. For 1993, petitioners reported on Schedule C a loss of

$48,483 from the operation of Stanton Mexicatessen, and interest

expenses of $10,277 on Schedule A. For 1994, petitioners did not

file a Schedule C and did not report any income or loss from the

operation of Stanton Mexicatessen.

Petitioners filed Form 4797, Sales of Business Property, for

1994 and reported a loss from the sale of Stanton Mexicatessen's

assets of $123,557 (less a $4,712 gain from the disposition of

other restaurant property for a net loss of $118,845). Form 4797

reported a sales date for the restaurant of January 1, 1994. 

Notice of Deficiency

Respondent asserts that petitioners gave Ms. Eagatatt a

security interest in the assets of Stanton Mexicatessen, as opposed

to selling the restaurant to her. Accordingly, respondent

determined that because petitioners did not sell Stanton

Mexicatessen, they are not entitled to the claimed capital loss for

1994. As a consequence of that determination, respondent

determined that petitioners failed to report the restaurant income

for 1994, and further, that they underreported the restaurant

income for 1992 and 1993. Respondent, therefore, reconstructed

petitioners' restaurant income for each of the years in issue by

determining the net profit from the restaurant as 3 percent of the

restaurant's gross receipts (as reported by petitioners in 1992 and

1993, and as reported by Ms. Eagatatt in 1994).
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2 Other adjustments in the notice of deficiency relating

to self-employment taxes are computational and not in dispute. 

Respondent also determined that petitioners were not entitled

to claimed investment interest expense deductions for 1992 and

1993. Finally, respondent determined accuracy-related penalties

pursuant to section 6662 for each of the years in issue and

additions to tax pursuant to section 6651(a) for petitioners'

failure to timely file their tax returns for each of the years in

issue.2 

OPINION

Issue 1. Sale of Restaurant

The first issue for decision concerns the nature of the

transfer of Stanton Mexicatessen to Ms. Eagatatt, that is, whether

petitioners sold the assets of the restaurant to Ms. Eagatatt, as

petitioners assert, or merely gave her a security interest in the

assets of the restaurant, as respondent maintains.

Preliminarily, we note that although petitioners reported the

sale of the restaurant on their 1994 tax return, the transaction in

fact occurred on September 15, 1993. (Petitioners maintain they

reported the loss from the purported sale of the restaurant on

their 1994 tax return on the advice of their accountant.) Because

the transaction occurred in 1993, petitioners are not entitled to

the loss in 1994, and we sustain respondent's determination for

that adjustment for that year. See sec. 165(a). However, because
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we have jurisdiction over petitioners' 1993 tax year, we shall

address petitioners' entitlement to a loss deduction in 1993. Sec.

6214.

Under section 165(a), taxpayers generally are entitled to

deduct losses not otherwise compensated for by insurance or

otherwise. Section 165(c) limits the deductions of noncorporate

taxpayers to losses incurred in a trade or business activity, a

for-profit activity, or casualty and theft losses.

To decide whether a taxpayer is entitled to a loss as the

result of a sale which is a part of a trade or business or forprofit activity, we must first determine whether a sale is deemed

to have occurred. "The term 'sale' is given its ordinary meaning

for Federal income tax purposes and is generally defined as a

transfer of property for money or a promise to pay money." Grodt

& McKay Realty, Inc. v. Commissioner, 77 T.C. 1221, 1237 (1981)

(quoting Commissioner v. Brown, 380 U.S. 563, 570-571 (1965)).

Whether a sale has occurred depends on the facts and circumstances.

Haggard v. Commissioner, 24 T.C. 1124, 1129 (1955), affd. 241 F.2d

288 (9th Cir. 1956). The relevant factors to be considered include

whether legal title passes; how the parties treat the transaction;

and whether an equity was acquired in the property. See Grodt &

McKay Realty, Inc. v. Commissioner, supra.

At trial, Mr. Rungrangsi testified that he sold Stanton

Mexicatessen to Ms. Eagatatt on September 15, 1993, apparently in
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order to place the restaurant's assets outside the reach of

creditors. He asserted that he neither owned nor operated the

restaurant after September 15, 1993, and that he thereafter

considered Ms. Eagatatt to be the owner of the restaurant.

Based on the entire record, we conclude that no sale took

place. Mr. Rungrangsi admitted that the restaurant's business

license remained in petitioners' names after September 15, 1993.

Indeed, the record is unclear when and if the license was ever

changed. The business checking account at Sanwa bank was never

changed to make Ms. Eagatatt a signatory thereon, or to remove

petitioners as signatories. More importantly, petitioners

continued to utilize the Sanwa business checking account after

September 15, 1993, in the same manner as they had previously used

the account--drafting checks out of the account and endorsing and

depositing checks into the account.

During 1994, petitioners made deposits totaling $107,945.98

into the Sanwa business checking account and wrote checks totaling

$52,238.21 for apparent business expenses out of the Sanwa business

checking account. Further, during 1994 petitioners wrote checks to

themselves or for personal expenses out of the Sanwa business

checking account. 

Even though the bulk sale notice indicated that Ms. Eagatatt

would be responsible for all of Stanton Mexicatessen's liabilities,

during 1994 petitioners continued to write checks to First
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International Bank (which issued the $100,000 small business loan)

and to Ms. Finkelstein (the seller who financed $85,000 toward the

purchase of the restaurant) out of the Sanwa business checking

account. (Mr. Rungrangsi admitted that the loan documents for

First International Bank were never amended to reflect the

assumption of the liabilities by Ms. Eagatatt and that he continued

to make payments to the lenders.) No checks from any business

checking account were ever written to Ms. Eagatatt. 

We also note that Stanton Mexicatessen's Form 940-EZ,

Employer's Annual Federal Unemployment (FUTA) Tax Return, dated

February 28, 1994, and Form 941, Employer's Quarterly Federal Tax

Return, dated February 25, 1994, were both signed by Mr. Rungrangsi

and identified him as the owner. 

Most compelling, however, is the testimony of Ms. Eagatatt.

Although Ms. Eagatatt filed a Schedule C with her 1994 income tax

return and reported a $6,291 loss from the operation of Stanton

Mexicatessen, she conceded during an Internal Revenue Service (IRS)

audit of her 1994 return that she was not entitled to the loss.

Ms. Eagatatt testified that she knew nothing about the restaurant--

she had only visited the restaurant once and did not even know the

address or generally what city the restaurant was located in.

Further, she testified that she never received any money from the

restaurant's operation. 
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Ms. Eagatatt explained that she lent petitioners proceeds from

the equity in her house because she was a friend of petitioners and

wanted to help petitioners with their business. At the time of the

loan (for the purchase of the minimarket), Ms. Eagatatt was not

aware that her house might be foreclosed upon if petitioners failed

to repay. It was only later that Ms. Eagatatt discovered that she

had no security if petitioners failed to make payments to Ms.

Eagatatt's bank lender, so she asked petitioners to place the

restaurant in her name. Thus, the purpose of placing the

restaurant in Ms. Eagatatt's name was to give her a security

interest in the restaurant's assets, and nothing more: 

Q. And when you signed the document, Exhibit 25-Y

[the bulk sale notice], what was your intent?

A. Just want to be the name in the restaurant.

Q. Did you intend to buy the restaurant?

A. I wanted the restaurant to be under my name, and

I don't know how to do the restaurant. That's the only

thing I want, the name under the restaurant.

 * * * * * * *

Q. If the business was sold [to a third party] for

more than $94,000 [the outstanding balance of Ms.

Eagatatt's home equity loan on September 15, 1993], did

you expect to receive that full amount or just $94,000?

A. Just for the equity--the equity loan, and that's

it.

 * * * * * * *

Q. And who would get the proceeds that exceeded the

$94,000?
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A. Whatever who want. I don't--

Q. Would that be Mr. Rungrangsi?

A. Should be.

It is evident that the benefits and burdens of ownership of

the restaurant were never transferred to Ms. Eagatatt, see Grodt &

McKay Realty, Inc. v. Commissioner, supra, and petitioners

continued to retain significant control over the restaurant and its

operation, see Tolwinsky v. Commissioner, 86 T.C. 1009, 1041

(1986); see also Helvering v. Clifford, 309 U.S. 331 (1940); Hilton

v. Commissioner, 74 T.C. 305 (1980), affd. 671 F.2d 316 (9th Cir.

1982); Miller v. Commissioner, 68 T.C. 767 (1977). The transfer of

the restaurant to Ms. Eagatatt was intended to create a security

interest, see Hedrick v. Commissioner, T.C. Memo. 1980-54; see also

Helvering v. F.& R. Lazarus & Co., 308 U.S. 252, 255 (1939), and it

is well settled that the mortgaging of property does not constitute

a sale or exchange, Woodsam Associates, Inc. v. Commissioner, 16

T.C. 649, 653-654 (1951), affd. 198 F.2d 357 (2d Cir. 1952); Lutz

& Schramm Co. v. Commissioner, 1 T.C. 682, 689 (1943). "[T]axation

is not so much concerned with the refinements of title as it is

with actual command over the property taxed--the actual benefit for

which the tax is paid." Corliss v. Bowers, 281 U.S. 376, 378

(1930).
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To summarize, we find that the September 15, 1993, event was

not a sale, and therefore we hold that petitioners are not entitled

to a loss in connection therewith for either 1993 or 1994.

Issue 2. Unreported Income for 1992-94

Having found that petitioners owned Stanton Mexicatessen after

September 15, 1993, we proceed to decide the amount of income from

the restaurant petitioners should have reported both before and

after that date.

According to IRS Revenue Agent Julia Chang who conducted

petitioners' examination, petitioners were unable to produce any

books or records to substantiate the income and expenses for

Stanton Mexicatessen for the years in issue, and none were

introduced into evidence at trial. Revenue Agent Chang testified

that because of the large number of cash transactions, a bank

deposits analysis was considered inappropriate. Consequently,

Revenue Agent Chang reconstructed petitioners' income from the

restaurant by analyzing industry standards. She utilized the RMA

Annual Statement Studies 1994 for the relevant time period, which

indicated that the industry standard for net profits before tax for

restaurants with gross receipts of less than $500,000 was 3 percent

of gross receipts. Therefore, she reconstructed petitioners' net

income for the restaurant based on the product of 3 percent of

petitioners' reported gross receipts for 1992 and 1993. For 1994,
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Revenue Agent Chang utilized the gross receipts reported by Ms.

Eagatatt. 

Where taxpayers fail to maintain adequate books or records,

the Commissioner is entitled to reconstruct the taxpayers' income

through indirect methods. Holland v. United States, 348 U.S. 121,

134 (1954); Webb v. Commissioner, 394 F.2d 366, 371-372 (5th Cir.

1968), affg. T.C. Memo. 1966-81; Petzoldt v. Commissioner, 92 T.C.

661, 686-687 (1989). In the case herein, respondent utilized a

variation of the so-called percentage markup method which is a

permissible method of reconstructing income, see Bollella v.

Commissioner, 374 F.2d 96 (6th Cir. 1967), affg. T.C. Memo. 1965-

162; Bernstein v. Commissioner, 267 F.2d 879, 880 (5th Cir. 1959),

affg. T.C. Memo. 1956-260; Stone v. Commissioner, 22 T.C. 893, 905-

906 (1954), and has been applied in situations involving

restaurants, see Edgmon v. Commissioner, T.C. Memo. 1993-486;

DiLando v. Commissioner, T.C. Memo. 1975-243. We have previously

sustained deficiency determinations where the Commissioner has

applied the percentage markup method based on a percentage of gross

receipts. See Ginzburg v. Commissioner, 14 B.T.A. 324 (1928);

Klebanoff v. Commissioner, T.C. Memo. 1973-174.

Petitioners did not introduce any evidence to establish the

correct amounts of their income. Instead, Mr. Rungrangsi, in

questioning Revenue Agent Chang, attempted to challenge her basis

for using the percentage markup method and her failure to contact
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3 We note that Revenue Agent Chang worked with

petitioners' accountants because Mr. Rungrangsi signed a power of

attorney to the accountants.

him directly (rather than his accountants) for information about

the restaurant.3 

Petitioners failed to present any credible evidence that shows

respondent's determination was erroneous. Rule 142(a); Welch v.

Helvering, 290 U.S. 111 (1933). In general, we do not look behind

the notice of deficiency and consider the actions or determinations

of a revenue agent, and we shall not do so here. See Greenberg's

Express, Inc. v. Commissioner, 62 T.C. 324, 327-328 (1974). Thus,

we sustain respondent's determination relating to the

reconstruction of petitioners' income for the operation of Stanton

Mexicatessen for each of the years in issue.

Issue 3. Interest Expenses

The third issue for decision is whether petitioners are

entitled to investment interest expense deductions for 1992 and

1993 (and which, according to the notice of deficiency, have

carryover consequences to 1994).

Respondent disallowed $12,221 of interest expenses in 1992 and

$10,277 of investment interest expenses in 1993 as deductions

because petitioners failed to substantiate the expenses or

establish their entitlement to such deductions. Petitioners

contend that the disputed interest expenses represent interest paid

pursuant to the loans from First International Bank (for the small
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business loan) and Ms. Finkelstein (for the restaurant acquisition

financing). 

Section 163 generally allows the deduction of interest paid on

indebtedness during the taxable year. Section 163(d)(1) limits the

deduction for investment interest to the extent of net investment

income. Investment interest means interest paid on indebtedness

allocable to property held for investment. Sec. 163(d)(3)(A).

Property held for investment includes any interest held by the

taxpayer involving the conduct of a trade or business which is not

passive activity and with respect to which the taxpayer did not

materially participate. Sec. 163(d)(5)(A)(ii). Net investment

income means investment income (gross income from property held for

investment and net gain from the disposition of property held for

investment) over investment expenses. Sec. 163(d)(4)(A) and (B).

Petitioners have not shown that they received any offsetting

investment income during 1992 or 1993. Thus, they are not entitled

to a deduction for investment interest expenses for those years. 

Cf. Scott v. Commissioner, T.C. Memo. 1997-507. Arguably, the

interest expenses paid by petitioners were not for investment

interest, but were instead for interest indebtedness incurred in

the operation of a trade or business and which is not subject to

limitation under section 163. See King v. Commissioner, 89 T.C.

445, 463 (1987); Paoli v. Commissioner, T.C. Memo. 1988-23. But if

the interest expenses were for trade or business indebtedness, such
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expenses would already be allowed and provided for in the

reconstruction of petitioners' restaurant income. And, in fact,

petitioners did report on Schedules C interest expenses of $9,938

for 1992 and $12,100 for 1993. Thus, to both allow deductions for

these interest expenses on Schedules C and for trade or business

interest expenses on Schedules A would amount to the allowance of

double deductions. Consequently, respondent's determination

disallowing $12,221 of interest expenses for 1992 and $10,277 of

interest expenses for 1993 is sustained.

Issue 4. Failure To File Additions to Tax

The fourth issue for decision is whether petitioners are

liable for the addition to tax pursuant to section 6651(a)(1) for

failing to timely file their income tax returns for each of the

years in issue.

Section 6651(a)(1) imposes an addition to tax of 5 percent for

each month or fraction thereof in which an income tax return is not

filed after the prescribed filing date. An exception is made for

reasonable cause not due to willful neglect.

Although the record on this issue is vague, petitioners

concede that they did not timely file their tax returns for the

years in issue. Respondent contends that the 1992 return was filed

on August 18, 1993, the 1993 return was filed on June 1, 1994, and

the 1994 return was filed on May 14, 1995.
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Petitioners assert that they were entitled to automatic 4-

month extensions for the filing of their returns for each of the

years in issue. In order to obtain an automatic 4-month filing

extension, the taxpayer must satisfy three requirements. The

taxpayer must: (1) Prepare and sign Form 4868, Application For

Automatic Extension of Time to File U.S. Individual Income Tax

Return; (2) file Form 4868 on or before the date on which the tax

return is due; and (3) properly estimate the tax due for such

taxable year and remit the unpaid balance. Condor Intl., Inc. v.

Commissioner, 98 T.C. 203, 224 (1992), affd. in part and revd. in

part on other grounds 78 F.3d 1355 (9th Cir. 1996); see also sec.

1.6081-4, Income Tax Regs.

Petitioners did not offer any copies of Forms 4868 for the

years in issue or other evidence to establish that they satisfied

the requirements for obtaining the automatic extension. Moreover,

they offered no proof as to whether they had reasonable cause for

failing to timely file their returns. Thus, we sustain

respondent's determination as to the addition to tax pursuant to

section 6651(a) for each of the years in issue.

Issue 5. Accuracy-Related Penalties

The final issue for decision is whether petitioners are liable

for the accuracy-related penalty due to negligence or disregard of

rules or regulations pursuant to section 6662 for each of the years

in issue.
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Section 6662 imposes an accuracy-related penalty equal to 20

percent of the portion of the underpayment attributable to

negligence or disregard of rules or regulations. "Negligence"

means any failure to make a reasonable attempt to comply with the

provisions of the Internal Revenue Code, and "disregard" means any

careless, reckless, or intentional disregard. Sec. 6662(c); see

also Neely v. Commissioner, 85 T.C. 934, 947 (1985).

No accuracy-related penalty is imposed with respect to any

portion of the understatement in which the taxpayer acted with

reasonable cause and in good faith. Sec. 6664(c)(1).

Mr. Rungrangsi testified that he relied on his accountants in

preparing the tax returns for the years in issue. However, he did

not establish that he provided his accountants with all the

information necessary for them to prepare petitioners' returns

properly. Petitioners' accountants did not testify at trial, and

the parties stipulated that petitioners did not have any books or

records reflecting the income or expenses of Stanton Mexicatessen

for the years in issue.

Reliance on an accountant to prepare tax returns is not

sufficient by itself to establish reasonable cause. See Metra Chem

Corp. v. Commissioner, 88 T.C. 654, 662 (1987). The taxpayer must

also show that he supplied the tax preparer with complete and

accurate information so that the return could be properly prepared,

an incorrect return was the result of the tax preparer's mistakes,
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and the taxpayer in good faith relied on the advice of a competent

tax preparer. Jackson v. Commissioner, 86 T.C. 492, 539-540

(1986), affd. 864 F.2d 1521 (10th Cir. 1989). Petitioners have not

established that they acted with reasonable cause and in good faith

in relying on their accountants to prepare their tax returns for

the years in issue; they have also failed to demonstrate that they

maintained books and records in accordance with section 6001.

Consequently, we hold that petitioners are liable for the accuracyrelated penalty pursuant to section 6662 for each of the years in

issue. 

To reflect the foregoing,

Decision will be entered

for respondent.